How to Tell if Bond Funds are Right for You or Not
As specialists in municipal bonds for the individual investor, Stoever Glass account representatives are frequently asked questions concerning tax-exempt trusts-or "municipal bond funds" as they are more often called. Investors are anxious to know which funds are the best investments for them. And, they want to know who should and who shouldn't be investing in the funds.
For over 45 years, Stoever Glass has been advising investors that the single most important thing to know about tax-free investments is how to select the investment best suited to one's own specific needs and goals.
For over 45 years, Stoever Glass has been advising investors that the single most important thing to know about tax-free investments is how to select the investment best suited to one's own specific needs and goals. From our first Portfolio Planning Kit and throughout our periodic educational reports we have always emphasized the importance of this selection process. We have in fact established an industry-wide reputation for showing investors how to determine their individual needs and for suggesting the specific investments, which will offer the best combination of safety, liquidity and return to meet those needs.
In direct contrast, is the one-size-fits-all philosophy of the municipal bond funds, which offer investors shares in pre-packaged portfolios, which are sold more for the brokers' convenience and profit than for benefit to investors. It has always been our opinion that this one-size-fits-all philosophy is not suited to the majority of investors. In fact although we make much more money selling bond funds than individual municipals we dissuade over 90% of our clients from buying municipal bond funds-suggesting more appropriate tax-free investments instead.
Still, we agree that even the one-size-fits all investment fits some investors perfectly well. And, for this reason we have written this special report to help investors who may benefit from fund investments. In this report, we'll show you how to tell if the funds are right for you or not and how to tell which ones are most suitable.
Should You Choose Funds?
Anyone considering bond funds should ask themselves two qualifying questions before deciding to invest. The first qualifying question is: Are long-term current-income bonds better for you than short-term bonds? This is of utmost importance because most bond funds are made up entirely of very long-term bonds. (The prospectus usually shows the "average weighted maturity’’ to be about 25 years out.) Consequently, when you buy shares of a bond fund you're actually buying long-term bonds. And as we have illustrated so often in our past reports the longevity of the term-the element which gives long-term bonds their attractive current yields--is also the very element which makes them the most vulnerable to price fluctuations when the market changes. And while funds offer "daily liquidity " don't be fooled into thinking that this is a high yielding place for a short-term investment. It is not. That liquidity only means you'll get net asset value per share for your holdings according to the market on the day you sell--not necessarily anything close to what you paid. That means you could get hurt badly if you have to sell when the market is off. In contrast short-term bonds pay less but they protect your principal much better. That's why you should consider funds only when the high return a long-term bond offers is more important to you than safety of principal--when defined as liquidity at or near the price you paid. That's the only time long-term bonds or the funds which package them are better for you than the shorter-term alternatives.
To give you a better idea of what we mean, an example of someone who should not look long-term would be a doctor or businessperson in their forties or fifties, earning $200,000 or more per year. Since they’re already earning a high salary, the better protection of principal that shorter bonds offer should be more important than the high current income a long-term bond offers. For most retired investors, who don’t expect to sell, the extra current return of long bonds would be a means of enhancing their lifestyle. So for them, the higher current income is more important.
With this distinction in mind, ask yourself if your goals and circumstances dictate that a higher return is more important to you than liquidity of your principal at or near the price you paid. If not, you can stop reading right here. The funds are not for you.
For the roughly 30 or 40% of you who should still be reading, here is the second qualifying question: Do you have a total of $100,000 or more to invest?
Quite frankly, if you do, our account representatives will continue to dissuade you from purchasing funds even though we make much more profit on funds than we do on bonds. That's because funds are simply a much more expensive method to get the diversity you have sufficient means to get on your own. Most people don't realize that many funds contain only 10-15 different bonds. So even an investor with a total of $100,000 to invest is already in position to put together a diversified portfolio of individual bonds of better quality and more yield than the funds offer. That's because the funds charge a fee for their "packaging" services. The fee is roughly 3%, and that's added on to, not in place of, the regular spreads all underwriters and dealers make. So buying $100,000 worth of a fund is like sending the broker $100,000 for the bonds, and an additional $3,000 for packaging a diversified portfolio for you. Obviously, the more you have to invest, the more you can diversify on your own, and the less reason there is to pay an extra 3% to get diversification through the funds. So, in conclusion, bond funds are suitable for those investors with less than a total of $100,000 to invest, and who find that long-term investments best suit their needs. The 3% extra service charge then becomes worthwhile because the bond funds enable you to achieve diversification similar to that which larger investors can obtain on their own.
In the next section of this report, we point out some of the advantages the funds offer to those of you who have passed the two qualifying suitability questions. We'll outline some of the ways you can take advantage of these benefits, and point you toward the particular type of funds you should consider.
Funds Advantages, For Fund Investors
At Stoever Glass we do not sponsor a specific fund, and that works to your distinct advantage. We have no reason, other than your best interest, to sell you one fund instead of another. We buy from the various sponsors at a dealer’s discounted price and sell at the same retail price the sponsor sells it for. We make about the same profit no matter which fund we sell, and you pay the same whether you buy from us or direct from a sponsor. So we have the unusual luxury of choosing, from the many, only those funds which are the best values at the time. And different funds will be better buys at different times. In contrast, brokers that sponsor funds are obviously obligated to sell their own funds in preference to all others, regardless of the available alternatives.
And since we are at liberty to offer any fund on the market, we can offer a more diverse selection of the various funds.
However, while there are choices to be made within each category, every unit trust falls neatly into one of four basic categories--national or single state; either insured or uninsured. As the names imply, national funds consist of issues from a variety of states while single state funds contain bonds of a single state and with it, the exemption of income from that state’s taxes as well as federal taxes. Either type, without insurance, generally features issues with a minimum quality of A-rated. Insured funds have higher ratings.
All four types offer investors the same basic advantages.
The first and most advertised attraction is that they offer the investor with less than $100,000 to invest, a chance to get diversification similar to that which more substantial investors can achieve by purchasing specific bonds individually. And while the fund investor cannot pick and choose the issues, maturity dates, or interest amounts independently, the funds maintain certain quality levels and offer high yields, although not as high as the long-term bonds which comprise the fund.
The second advantage shared by most funds is that they offer investors a monthly payment plan for receiving interest income. Instead of a semi-annual interest payment, the investor can opt for a monthly check. This option is clearly an extra benefit for retired persons or for any investor whose main concern is current income. Most funds offer slightly lower yields to those who select the monthly payment plan, but we think it’s a worthwhile feature.
The third advantage offered by the funds is convenience. To buy or sell fund shares, all the investor has to do is call any broker and place the order. They need not take the time or trouble to select their own portfolio—the fund's sponsor is a qualified professional whose job is to select the bonds.
A Red Flag
Most funds also offer investors an option to automatically reinvest interest payments if current income is not a concern. But this should set off a warning signal. After all, if current income is not a concern, you should not be buying funds in the first place—as we explained earlier! This reinvestment option is contradictory to the purpose of the fund and therefore we do not recommend it. If you are not concerned with current income, you would be much better off with shorter term bonds which emphasize better protection of your principal.
Insured or Uninsured ?
The insured funds, whether national or single state, offer the extra security of insurance which backs the fund. This is an attractive feature for those investors who don't feel comfortable with bonds which are A-rated but, still like the other advantages funds offer. Of course you give up some current return for this added security. The insurance usually costs you about .20 percentage points in yield, so while the insured funds appeal to investors who are seeking increased security, they also reduce your current return. Uninsured funds, on the other hand, are for investors who place more emphasis on yield, and feel sufficiently secure with an "A-rated" diversified portfolio.
National or Single-State?
If you live in a high-tax state such as New York, New Jersey, Massachusetts or California, you can’t beat the extra benefit of double, and sometimes triple tax-exemption of the single state funds. New York residents, for instance, would need to find a national fund offering a 5.42% yield in order to match the extra tax exemptions of a New York fund yielding 4.75%. California residents would require 5.25% from a national fund to match a 4.75% return from a California fund. Where individual state and local taxes are minimal or nonexistent, such as in Florida, Texas or Washington, national funds are the best choice.
Once again, remember that at Stoever Glass our account representatives are at liberty to suggest their preferences based upon yields, safety and marketability as it relates to your specific needs. Our recommendations may vary from sponsor to sponsor and from month to month, depending on what is available, because our representatives are in a position to examine each fund independently, from the investor's point of view. That's why your Stoever Glass representative is in the best position to help you decide which funds are best for you.
The choice between a one-company agent and an independent agent should be clear.
We'll scour both the new-issue market as well as the secondary market to find the best fund for you.
© Copyright 1983, Stoever Glass & Co., Inc
Although the above information and statistics are not guaranteed, they have been obtained from reliable sources and are believed to be accurate.